Strike price selection should be a focus when selling call and put options. With the stock market bearish and volatile at the start of 2016, this article will highlight how such choices will offer significant protection while still allowing for compelling returns. The stock I selected to demonstrate the main points is Adobe Systems, Inc., a stock that has appeared on our Premium Watch List over the years although it is currently not on that list. I chose this stock because its option returns are typical of the securities normally found on our list and because it does not report earnings during the February contracts as we enter another earnings season.
In my books and DVDs I always stress that we should favor deeper-out-of-the-money puts (lower than current market value) and in-the-money calls (also lower than current market value) when a defensive posture is indicated as it is now in my view.
Options chain for ADBE
Note that the out-of-the-money $87.50 put generates $2.09 and the in-the-money $87.50 call generates $4.35. To afford maximum protection, we will first sell the out-of-the-money put so let’s feed the information from the options chain into the BCI (single-column) Put Calculator.
Put calculations for ADBE
Note that if ADBE does not drop below the $87.50 strike from $89.00 by expiration, we will have generated a 2.45%, 1-month return which annualizes to 25.52%. If the stock price dips below the strike, our cost basis (breakeven) is $85.41 or a 4.03% discount from current market value. If this latter scenario occurs and the shares are put to us (we can always buy back the option if we do not want to take possession of the shares) we can then sell an in-the-money call option. For purposes of this article, we will extrapolate a bit and assume a similar return next month for the call as we would receive this month.
Call calculations for ADBE
Note that the in-the-money strike generates a 3.3% (40% annualized), 1-month initial return with 1.7% downside protection OF THAT PROFIT. This means a breakeven of 5.0% (3.3% + 1.7%).
In this hypothetical scenario based on a real-life options chain, our 2-month breakeven protection on the put side is 4.03% and on the call side is 5.0% for a total breakeven protection of 9.03%. This means that to lose money ADBE would have to decline in value to below $80.96. If, on the other hand, the markets calm, there is opportunity to generate significant monthly returns.
Strike price selection is a powerful tool at our disposal to navigate through bear and volatile markets. Deeper-out-of-the-money puts and in-the-money calls should be given serious consideration in these market conditions. Navigating difficult markets is not for everyone. We must be comfortable and trade within our own personal risk-tolerance. That said, staying on the sidelines until the markets calm is another consideration.
Upcoming live appearances
1- Saturday January 23rd, 2016: Kansas City, Missouri
9 AM – 12:30 PM
Matt Ross Community Center
2- New York Stock Traders Expo
February 21st – 23rd
Marriott Marquis Hotel, NYC
JUST ADDED: I was recently invited to speak at The Money Show Las Vegas event on May 10th, 2016 at Caesar’s Palace.
This has been the worst 10-day calendar start to an investment year in history. Global markets remained bearish this week reflecting concerns that US growth is slowing and raised questions about whether the US Federal Reserve will be able to pursue its forecast of four rates hikes in 2016. Having fallen 21% since its late December high, the Shanghai Composite Index is officially in bear market territory, defined as a drop of 20% or more from its recent high. Oil extended its decline, dropping below $30 late in the week. Slowing global growth, high supply from the U.S. and anticipation of additional supply hitting the markets when sanctions are lifted on Iran are adding to the bearish backdrop for oil and other commodities. Oil ends the week at 12-year lows and bankruptcy fears in the oil sector continue to grow. All this added up to another down week to start 2016. This week’s US economic reports:
- The Fed’s Beige Book, prepared in advance of the January 26–27 Federal Open Market Committee meeting, was less gloomy than many recent headlines
- Growth remains modest to moderate across most Fed districts amid few signs of wage or price pressures, according to the report
- Comments from several regional Fed presidents during the week were less upbeat. For example, Boston Fed president Eric Rosengren, a voter in 2016, said sluggish global and US growth may force a more gradual pace of tightening than officials currently expect
- The European Central Bank released an account of its December meeting that showed that there was a split over the need for further stimulus in the eurozone. The ECB surprised markets by not implementing more aggressive stimulus measures at their December meeting (not a US report, but impacts us)
- December US retail sales fell 0.1%. For all of 2015, retail sales rose a 2.1%, the slowest sales growth since 2009
- US industrial production contracted 0.4 in December and January’s Empire State manufacturing survey fell to -19.4 from 4.6 in December, setting off a fresh round of concern that US growth is rapidly losing momentum
- Corporate earnings for the final quarter of 2015 began to be released this week. Though it is still very early in the process, it is notable that among large banks that have reported thus far, most have exceeded expectations, finally a silver lining
- The Fed sent a record $97.7 billion in profits for 2015 to the US Department of the Treasury this week
- The central bank sent $19.3 billion in excess capital to the Treasury Department under the terms of the recently enacted federal highway bill. Fed chair Janet Yellen has protested the return of capital, saying it sets a bad precedent and infringes on the Fed’s independence
For the week, the S&P 500 declined by 2.17% for a year-to-date return of – 8.01%%.
IBD: Market in correction
GMI: 0/6- Sell signal since market close of December 10, 2015
BCI: Moving 1/3 of my stock investment portfolio into cash short-term. Favoring only deep out-of-the-money puts and in-the-money calls on active positions. Reducing my monthly goal for initial returns to 2% – 3% to decrease volatility risk. February contracts are 5-weeks long so I plan to hold off a few days into this coming week before taking new positions. Plan to get more aggressive when markets calm.